What Is A REIT? Real Estate Investment Trusts, Explained

Investing in real estate is an enticing proposition for many. However, investing in individual properties requires both a financial and mental commitment that not every investor is willing to make. Real estate investment trusts (REITs) offer a solution that provides exposure to real estate in your investment portfolio without the physical work often associated with investing in real estate.

But what is a REIT? We will explore how REITs work and whether they fit into your investment portfolio.

A REIT owns, operates or finances properties that produce income in a particular sector of the real estate market. Investors can buy publicly traded shares in a REIT, a REIT fund on major stock exchanges or a private REIT to diversify their portfolio and generate income.

The Internal Revenue Code (IRC) defines how REITs are formed and the guidelines they must follow regarding asset taxation. The Code specifies that REITs must hold 75% of their assets in cash, treasuries or real estate, and must distribute 90% of its taxable income in shareholder dividends each year.

REITs make their money through the mortgages underlying real estate development or on rental incomes once the property is developed. REITs provide shareholders with a steady income and, if held long-term, growth that reflects the appreciation of the property it owns.

As an investor, you won’t need to commit time to managing a rental property. Instead, you’ll gain exposure to real estate in your portfolio without the occasional headaches of being a landlord.

To qualify as a REIT, a company has to meet certain requirements as outlined by the IRC. In order to be considered a REIT, a company must:

• Be a taxable corporation that is managed by a board of directors or trustees
• Have at least 100 shareholders after the first year
• Acquire 75% of gross income from rent, interest on mortgages or real estate sales
• Invest a minimum of 75% of total assets in real estate, cash or U.S. Treasuries
• Pay at least 90% of taxable income in the form of shareholder dividends
• Have 50% or less or shares held by five or fewer people

Not every REIT invests in the same type of property. In general, REITs specialize in a particular type of property. Below is a closer look at some of the common types of properties REITs invest in.

Residential REITs

Residential REITs own and operate residential rental properties. These can include everything from single-family rentals to multifamily apartment buildings. The value of these REITs fluctuates along with the demand for rental housing. Residential REITs tend to be more recession-resistant, as housing and rent are a higher priority within most people’s budgets.

Commercial REITs

Commercial REITs concentrate on managing commercial properties. This category includes properties like shopping malls or other retail facilities, office buildings, warehouses or industrial facilities. They often offer higher returns than residential REITs because they’re more susceptible to economic fluctuations.

Health Care REITs

Health care REITs specialize in properties related to health care. Made up of senior housing communities, research centers and medical office buildings among others, these types of REITs come with their own benefits and risks. They work best in a diversified portfolio where other investments aren’t subject to changes in health care policy or medical demand.

Different types of REITs operate in different ways. Below is a closer look at some of the most common types of REITs to understand.

Mortgage REITs

Mortgage REITs (mREITs) derive their income from interest on mortgages. Each type of property is built with the proceeds of a mortgage, and some REIT investors collect the interest paid on the mortgage as income. They’re popular because they return the relatively high interest payments collected on commercial mortgages.

Commercial real estate mortgages come at a higher interest rate because they’re considered riskier than those underlying residential real estate. Thus, investors in commercial mortgage REITs will earn more interest (while assuming more risk) than those investing in residential real estate mortgage REITs.

Equity REITs

Properties can generate rental income, which, after collecting fees for property management, provides income to its investors. These REITs generate income from renting real estate to tenants. After paying expenses for operation, equity REITs pay out dividends to their shareholders on a yearly basis.

Hybrid REITs

Hybrid REITs contain both equity and mortgage holdings. They give investors more diversity, offering better protection from real estate market swings. They can work well with both income- and growth-oriented portfolios.

Publicly Traded REITs

Due to the accessible nature of publicly traded REITs, this is the way most people invest in real estate.

Publicly traded REITs trade on a stock exchange, such as the Nasdaq or the New York Stock Exchange (NYSE). They’re highly liquid – meaning they can be bought or sold at any time, so your money isn’t tied up – and are open to all types of investors. You can open a brokerage account with any online trading platform and begin purchasing REITs.

Publicly Non-Listed REITs

Publicly non-listed REITs are offered to all but not listed on stock exchanges. There are both legitimate reasons for this – as when a project requires a low profile for competitive reasons – and unscrupulous ones as well. These projects typically offer little transparency and often charge upfront fees, so you need to know who you’re dealing with and have a keen understanding of the project and its risk.

The potential upside is a bigger return that reflects the greater risk you’re incurring. However, there are significant potential downsides as well for novice investors. In addition to the risk of fraud, buying into a public non-listed REIT means you are forsaking the consumer protections and avenues of redress afforded by SEC regulations. 

Private REITs

Private REITs are not open to the public. They aren’t registered on the SEC and are only sold to institutional investors or accredited investors. These REITS usually have high minimum investments and are considered illiquid investments, as they can be very hard to sell.

As an individual investor, you can start investing in REITs through a major stock exchange. The process is as straightforward as purchasing a public stock through a stock exchange. If you are interested in private REITs, you may need to get connected to investment opportunities through your real estate network or financial advisor.

For investors who aren’t sure what kind of REIT is right for them, working with a fee-only financial advisor might help you find the right solution for your financial goals.

REITs offer investors several advantages compared to other types of investments. Below is a closer look at the benefits of investing in a REIT include:

Passive Real Estate Ownership

A passive real estate investment is one where you enjoy the benefits of real estate ownership without having to endure the headaches of managing the investment property.

Mandatory Distributions

As mentioned before, the IRS requires that REITs distribute 90% of their taxable income to shareholders. These payments come to investors in the form of annual dividends.

Generate Steady Income

Whether it’s an equity REIT collecting rent or a mortgage REIT collecting interest, these investments generate a regular, dependable income. That’s why REITs have traditionally been seen as a good investment for retirees, although with the real estate market booming, that view is beginning to change.

Liquidity

Because these investments can be bought and sold on major stock exchanges, REIT investors enjoy liquidity, or the ability to quickly convert an investment into cash. Investors who purchase real estate directly often run into cash-flow problems as physical real estate is illiquid, because it takes time to convert a property into cash.

Portfolio Diversification

REITs offer investors an opportunity to diversify their portfolio. You can gain exposure to real estate in your investment portfolio without committing to an individual property to manage on your own.

Like all types of investments, REITs also come with some disadvantages. Below is a closer look at some of the potential downsides of investing in REITs.

Slower Capital Appreciation

It’s long been believed that REITs don’t grow in value as quickly as other investments can. This is a reflection of that ongoing split in opinion about whether REITs or stocks are better investments in the long term. 

Taxed As Income

Unlike most real estate returns on investments, the dividends you receive from REITs are not given preferential tax treatment. Dividends are taxed as ordinary income. You should discuss with your financial planner whether the returns on this investment vehicle might move you into a higher tax bracket.

Sensitive To Interest Fluctuations

REITs tend to suffer in an environment of rising interest rates. Investors tend to switch to inflation-protected treasury bonds at those times because they are backed by the full faith and credit of the U.S. government.

As interest rates on consumer credit rise across the board, your shares may become less valuable relative to shares that are just as low risk but that offer a higher return because of rising mortgage rates.

REITs also have some potential downsides when compared to other investments.

Slower Capital Appreciation

It’s long been believed that REITs don’t grow in value as quickly as other investments can. This is a reflection of that ongoing split in opinion about whether REITs or stocks are better investments in the long term.

Taxed As Income

Unlike most real estate returns on investments, the dividends you receive from REITs are not given preferential tax treatment. Dividends are taxed as ordinary income. You should discuss with your financial planner whether the returns on this investment vehicle might move you into a higher tax bracket.

Sensitive To Interest Fluctuations

REITs tend to suffer in an environment of rising interest rates. Investors tend to switch to inflation-protected treasury bonds at those times, because they are backed by the full faith and credit of the U.S. government.

As interest rates on consumer credit rise across the board, your shares may become less valuable relative to shares that are just as low-risk but that offer a higher return because of rising mortgage rates.

If you’re looking to invest in a REIT, it’s important to be aware of REIT fraud. The Security and Exchange Commission (SEC) recommends using its Electronic Data Gathering, Analysis and Retrieval (EDGAR) system to verify the registration of a REIT before investing. The SEC also has a tool that allows users to verify that an investment professional is licensed and registered.

You have questions about REIT investments. We have answers.

Are REITs a good investment?

REITs offer an opportunity to include real estate in your investment portfolio without managing an individual property. For some investors, the ability to diversify their portfolio makes REITs a good investment opportunity.

What risks are associated with investing in REITs?

Some of the risks associated with investing in REITs include the potential for slower capital appreciation and the investment’s sensitivity to interest rate fluctuations. Additionally, income from a REIT is taxable as income, which can have implications for your annual tax bill.

What percentage of my portfolio should be in REITs?

The right percentage of REITs for your portfolio varies based on your investment goals and preferences. Investors seeking to diversify with REITs might make them a small portion of their portfolio. Investors who are more interested in real estate as an asset class might make REITs a larger component of their investment portfolio. It best to speak to a financial advisor who can understand your unique goals.

REITs can have a lot of value to offer investors. They’re more liquid than physical properties and can be a steady source of income. They can appreciate (and depreciate) along with the broader real estate market, and allow you to hedge against stock market volatility. But before investing, do your research. Consult a financial advisor to help you decide whether REITs should be part of your portfolio.

If you don’t think investing in a REIT is the right move for you, purchasing your own investment property could be a good alternative. Get approved with Rocket Mortgage® today to get started.